Our Insights

To access this premium content, we ask that you please provide us with a few details about yourself.

* Required

Name*

Company*

Email Address*

*The information gathered here about you is used to monitor Galliard’s website activity. The information gathered
will not be shared by Galliard, however it may be used to contact you. The information contained in Galliard publications reflects the
views of Galliard Capital Management, Inc. and sources believed to be reliable by Galliard as of the date of publication. No representation
or warranty is made concerning the accuracy of any data and there is no guarantee that any projection, opinion, or forecast herein will
be realized. The views expressed may change at any time subsequent to the date of publication. Galliard publications are for information
purposes only and are not investment advice nor a recommendation for a particular security strategy or investment product. Publications
on Galliard’s website are not to be shared, referenced or distributed without express written consent from Galliard. By checking this box
you are acknowledging agreement to the statements provided above.

Market opportunity

Background

The taxable municipal sector of the bond market has historically offered an opportunity to add value to a portfolio without sacrificing quality. Municipal
bonds, or “munis,” issued by states, cities and other governmental entities raise money to fund public projects such as schools, highways, hospitals,
and other public service infrastructure. Munis are an attractive option for those seeking tax-advantaged income due to the fact that the income
on these bonds is tax-exempt at both the federal and state level. Today, however, the universe of taxable municipal bonds has emerged as an attractive
institutional investment opportunity thanks to a confluence of factors that have built on the sector’s superior yield and low-default track record.

As a result, the market opportunity today in taxable municipals is vastly different from what it has been historically. Taxable municipal markets now
exhibit size, liquidity, and trading volume levels absent several decades ago. Moreover, the recent sharp decline in the percentage of monoline-insured,
AAA-rated muni bond issuance allows investors to be paid appropriately for the risks they choose to take. As an investor who has participated in
this muni market for the past 20 years, we believe the market as a whole has not fully recognized this value proposition.

The net result is a market which has become a viable alternative to the corporate bond market as well as an attractive option for long credit investors.

Rulemaking events spur growth

The United States taxable municipal bond market currently has about $623 billion of bonds outstanding.1 In 1985, the market had $2.6 billion
of bonds outstanding.2 Two rulemaking events spurred this growth. The Tax Reform Act of 1986 (The Reform Act) introduced more stringent
rules surrounding tax-exempt muni bond issuance, after which the taxable municipal market grew at an average rate of 26% per year through 2008.
In 2009, the American Recovery and Reinvestment Act introduced the Build America Bonds (BABs) program, and the market grew by over 50%.1,2

Tax reform act of 1986
How did the taxable muni market size increase 240 times between 1985 and 2015?1,2 Municipalities found it more challenging to issue tax-exempt
bonds due to the tax reform work surrounding muni bonds in the 1980s. The Reform Act laid the groundwork for taxable municipal market growth, and
instituted rules still shaping the market today. Specifically, the Reform Act established rules to discourage municipal arbitrage and to supplement
existing rules limiting the number of entities that could issue or benefit from the issuance of tax-exempt bonds.

Before the Reform Act, municipalities could take advantage of a significant arbitrage opportunity by issuing tax-exempt bonds and investing proceeds
in US Treasuries. For example, if a municipality could issue tax-exempt debt at 9% and invest the proceeds in US Treasuries yielding 10%, then
the municipality could collect 10% interest on its investment, pay just 9% on its newly-issued debt due to its exempt status, and keep the remainder
as profit. The Reform Act introduced provisions to tax away profits earned by municipalities in this way.

Similarly, the Reform Act solidified rules surrounding who is allowed to issue or benefit from tax-exempt bond issuance. At a high level, tax-exempt
issuers are limited to states and political subdivisions. The introduction of private activity bond rules sought to curtail beneficiaries of tax-exempt
issuance. For instance, prior to the Reform Act, the tax code was vague enough so that a municipality could issue tax-exempt bonds and then lend
those proceeds to entities other than states or political entities. Thus, a municipality seeking to attract private business could borrow at tax-exempt
rates and lend to a private business for capital expenditures. The Reform Act put provisions and tests in place to limit these liberties in the
tax code.

Build America Bonds and the American Recovery and Reinvestment Act
In 2009, at a time when most credit markets were seizing up, taxable municipal bond markets proved to be one of the more liquid credit subsectors and
experienced another surge in growth. This came thanks to the Build America Bonds (BABs) program introduced through the American Recovery and Reinvestment
Act of 2009. The program, which permitted municipalities to issue taxable bonds and receive a federal reimbursement for incremental interest costs,
expanded the available supply of the taxable municipal bond universe by over 50% ($182 billion) in 2009 and 2010.1,2 As a result, the
program aligned borrowers and savers by pairing municipal debt issuers seeking funding during the economic downturn with taxable bond investors
seeking credit diversification.

The BABs program not only introduced significant supply to the muni market, it also introduced a supply of long-term muni bonds, which is particularly
notable for long credit investors. In fact, as of June 30, 2015, the Wells Fargo Build America Bond Index had an average maturity of over 24 years.1 Thus, while the two-year BABs program was relatively short-lived in comparison to the long-lasting impact of the Tax Reform Act of 1986, the term
structure of the bonds issued under the program created a credit investment opportunity for many years to come.

Issuance has risen

Not surprisingly, taxable municipal bond issuance in the years following these two rulemaking events showed marked increase. Between 1970 and 1986,
no individual year witnessed more than $830 million of issuance. In the decade following the Reform Act however, an average of $6.3 billion of
taxable municipal bonds was issued annually.2 Meanwhile, 2009 and 2010 were banner years for issuance, as shown in Figure 1.
2011 to the present has also witnessed fairly solid supply, with over $30 billion of average annual new issuance. Much of this issuance has come
from issuers taking advantage of low rates to advance refund older tax-exempt bonds.

Figure 1 | Taxable municipal bond issuance by year1,2

One interesting trait of taxable municipal issuance is that it offers long credit investors proportionally more opportunities for investment than some
other bond market sectors. Since 1986, approximately two-thirds of all taxable municipal bonds issued each year were issued as 10-year or longer
bonds (Figure 2).2 Comparatively, corporate bonds typically offer a much lower percentage of 10+-year maturities. Since 2006,
for example, about 17% of all corporate bonds have been issued as 10-year or longer bonds.3

Figure 2 | Long bond issuance2

Trading volume is similar to corporates

Prior to 2009, the taxable municipal market was more of a “one-off” market with limited product, few active dealers, and marginal participation from
institutional investors. The BABs program sparked a dramatic change in the market by bringing in a new group of institutional investors and encouraging
dealers to increase their presence in the taxable muni market. Today, the taxable muni market has some of the liquidity characteristics of an institutional
bond market.

One measure of liquidity, the average daily trading volume as a percentage of market size, compares reasonably well to the corporate market. In the
four years following the end of the BABs program, daily trading volume for taxable munis was 0.16% of outstanding bonds versus corporate volume,
which was 0.29% (Figure 3).4 While the corporate market is much larger than the taxable muni market (Figure 4), liquidity
based on market-size-adjusted trading volume is relatively comparable.

Figure 3 | Average daily trade volume vs. market size (2011-2014)1,4

Figure 4 | Bond market size of select spread sectors-year end 20141,2

While liquidity is usually thought of as a singular characteristic, it is important to break it down into its two pieces: the ability to BUY or to
SELL bonds at a market price. Generally, investors should be more concerned with being able to sell an investment at a fair price in a reasonable
time frame. Fortunately, the post BABs world consists of an expanded dealer presence and substantial investor appetite. Sellers of taxable munis
are generally able to solicit many bids at fair levels, especially for higher-quality securities (rated AA- or better).

However, liquidity in the taxable muni market is not as robust as other institutional markets. The two options for purchasing taxable munis are either
in the new issue market or from the secondary market. In the post-BABs world, primary market issuance has decreased to more historic levels, with
an average of $34 billion issued annually from 2011 to 2014,2 thereby reducing the opportunities for investors to buy new issue. As
for secondary market activity, many investors are choosing to hold onto their current positions because of a desire to have exposure to the sector
and because of a lack of alternative investments, whether new issue taxable munis or other attractively priced taxable fixed income securities.
Given the challenges investors face in populating a diversified taxable muni portfolio, sourcing bonds becomes a critical component of the portfolio
management process.

Monoline Demise Makes More Heterogeneous Muni Market
Monoline insurance, offered by firms such as MBIA, Ambac, FSA, FGIC and
XLCA, was a common component of the municipal market until 2007. For an up-front fee, issuers or investors could purchase an insurance policy from
a private insurance company which guaranteed timely payment of principal and interest on a municipal bond.

Historically, monoline insurance played a prominent role in the municipal market. Investors were drawn to monoline insurance because it allowed them
to turn almost any municipal bond into a AAA-rated security for little cost while doing minimal credit research. From 2003 to 2007, monoline insurance
was purchased on over half of all new-issue municipal bonds. We believe this large penetration of insurance made the municipal market less attractive
for investors willing and able to do credit research because bonds were no longer priced to the underlying fundamentals but rather to the cost
of insurance.

However, during the credit crisis, monoline insurers experienced dramatic credit deterioration as their large guaranty exposure to non-agency mortgages,
collateralized debt obligations (CDOs), and other structured products came under significant pressure. Three of the five largest insurers were
taken over by insurance regulators, while the remaining insurers experienced multi-notch downgrades. This experience nearly ended monoline insurance
as it was no longer rated AAA, and the claims paying ability of insurers was severely diminished. Since 2009, less than 10% of municipal issuance
has been insured (Figure 5).5

Fortunately, for investors capable of devoting the resources necessary to underwrite and monitor municipal credits, the municipal market now provides
more opportunity to earn returns that would have otherwise been captured by monoline insurers or issuers.

The Index: A starting point for credit investors

The index is often a good starting point for understanding the opportunity set for bond investment. But munis work differently. Thus, investors in
mandates benchmarked by the Barclays U.S. Long Credit Index should be aware of two index-related factors. First, particularly since the BABs era
of muni bonds began, muni index presence has grown significantly. Second, due to the way index rules are written, the vast majority of muni issuers
are outside of the index. The net result is a muni market that offers credit investors opportunity to add value.

Index increases in taxable municipal bonds

Taxable municipals have become an increasingly sizeable part of credit indices. This is no surprise considering the magnitude of the BABs program in
2009 and 2010. For instance, munis went from about 3% of the Barclays U.S. Long Credit Index to nearly 13% between the beginning of 2009 and the
end of 2010 (Figure 6). Now, they account for about 8%6 of the index. Thus, a larger index presence today means that taxable
municipals now play a more significant role in performance numbers. Corporates, meanwhile, continue to constitute the majority of the index. Nonetheless,
their decrease from nearly 90% of the index to approximately 80%6 currently suggests that corporates are not the only option for high-quality
credit investors.

Figure 6 | Barclays U.S. long credit index composition6

Value in non-index bonds

Even with this increase in index-eligible taxable municipals, the majority of the investable muni universe lies outside the index. Herein lies the
opportunity to add value to a bond portfolio. In fact, about 64% — or over $350 billion — of the taxable municipal bonds that meet
the minimum 10-year maturity requirement for inclusion in the Barclays U.S. Long Credit Index are not in the index.2,7 Part of the reason
for this is strict index inclusion criteria, primarily the $250 million minimum issue size (Figure 7). Thus, while it may be helpful to
use the index as a starting point for long credit investment, investors ought to realize that the index is generally less diversified and more
concentrated in lower-quality issuers than it might otherwise be if it included smaller municipal bond issues.

Figure 7 | Key rules for barclays U.S. long credit index inclusion

The Galliard muni Portfolio: capturing value

The taxable municipal market has grown, presenting credit investors with additional opportunity to add muni bonds to their portfolios. The index reflects
this growth, and munis have become a larger portion of the index. However, since the majority of muni bonds lie outside of the index, the opportunity
for investors to add value abounds. This is precisely the value that Galliard aims to capture.

We believe our 20 years of experience investing in taxable municipals helps us to capture value by doing two things well — sourcing bonds and
managing credit risk. Our sourcing capability means we are able to leverage our widespread connections to purchase from a vast universe of bonds
that best fit our investment philosophy. Meanwhile, managing credit risk means that we select and hold creditworthy names expected to pay in full,
while avoiding deteriorating credits. We discuss these two important aspects of our strategy in the next two sections.

Sourcing

Galliard’s ability to source bonds from across an expanse of issuers has become a meaningful differentiator in building high-quality, diversified
taxable municipal portfolios. This means using our reach to select bonds that fit our investment profile, not simply purchasing the largest, most liquid,
and often times riskiest bonds in the index. Our strength in sourcing allows us to build portfolios diversified by issuer, by geography, and by type.

Unlike the corporate bond market where issuers prefer to issue large index-eligible deals and only a few bond maturities are offered at any one time,
municipal issuers tend to issue deals with bonds maturing annually for up to 30 years. The result is a market with many small bond issues outstanding
compared to the corporate market which has fewer bonds outstanding but where each bond is much larger in size. As such, nearly 75% of the taxable
municipal bond universe falls outside of the Barclays Capital U.S. Long Credit Index.2, 6 This creates an opportunity for Galliard to
add value through the sourcing of non-index bonds, which receive less attention from larger investors and dealers.

A critical component of sourcing smaller deals is strong relationships with the numerous and diverse set of broker-dealers that are involved in the
municipal market. Galliard has developed long-term relationships with a large number of broker-dealers across the country, including not only the
major Wall Street banks but also an extensive list of regional brokers and smaller, specialized brokers integral in the muni market. From 2009
to 2014, Galliard transacted with 70 brokers in the municipal market. We believe sell-side firms view Galliard as an important counterparty in
the taxable municipal market given our 20-year commitment, dedicated resources, and consistent participation in the market. This allows us to efficiently
source the bonds that best fit our portfolio’s objectives at favorable prices.

The Galliard process for minimizing credit risk begins with applying what experience has taught us and what credit statistics support: an efficient
way to reduce risk is to avoid speculative-grade issuers and to minimize exposure to the most troubled subsectors such as housing and hospitals.8Since
this is relatively straightforward, the bulk of Galliard’s credit underwriting and monitoring effort focuses on identifying high-quality, highly-rated,
general obligation (GO) and revenue bond issuers.

Galliard’s municipal research process is conducted in two steps: initial underwriting and ongoing monitoring. The initial underwriting analysis for
a new issuer in the Galliard portfolio focuses on a breakdown of financial statements and an analysis of each bond’s security, since each bond’s
security differs from other credit sectors of the bond market. The offering documents are the primary source of information during the underwriting
phase, especially for an evaluation of the security. Financial statement analysis is based off of the issuer’s Comprehensive Annual Financial Report
(CAFR). This information is supplemented by data and analytics from a third-party vendor that standardizes and populates a database of issuers’
financial statements. We also subscribe to a software provider that allows us to either perform in-depth analysis of individual issuers or comparative
analysis across a broad segment of the market, including our entire portfolio of 400+ issuers. With information from all of these sources, the
Galliard credit team discusses issuers during this initial underwriting phase which helps drive the purchase decision.

The second step, ongoing monitoring, is integral in retaining issuers which we believe are best suited for Galliard portfolios. In this step, we leverage
information from our third-party vendors to monitor changes in an issuer’s financial position, and in a similar fashion to the research process
described above, perform more in-depth qualitative analysis on issuers in the portfolio where warranted. We believe that this two-step research
process mitigates the formidable challenge posed to muni investors by the vast number of issuers and lack of centralized financial statements.
While estimates differ, there are between 50,000 and 80,000 municipal securities issuers.9, 10 This dwarfs the number of corporate issuers,
which is closer to 3,000.10 While the Municipal Securities Rulemaking Board has taken steps to centralize this information, the usability,
and comparability of the data is still challenging. As a result, being able to leverage vendors specializing in financial data enables us to streamline
the muni research process and manage credit risk.

By emphasizing sourcing bonds and managing credit risk, we strive to build well-diversified muni portfolios with high-quality issuers. This strategy
for municipal sector investment aligns with our firm’s overall investment philosophy of maintaining diversified portfolios with high-quality bonds
that allow us to earn the yield implied at the time of purchase. We believe this allows us — in a Pareto optimal sense — to earn an
appropriate risk-adjusted yield without taking on excessive credit risk (Figure 8).

Figre 8 | The Galliard taxalbe municipal portfolio

The emphasis on diversification translates into a larger number of holdings, as evidenced by the 400+ issuers we hold in the firmwide muni portfolio
(Figure 9). In client portfolios, credit position sizes are typically between 0.3% and 0.5% of any given portfolio’s market value.
This helps to limit the portfolio’s overall risk by limiting the idiosyncratic risk of any individual issuer.

Galliard’s high-quality muni bias is a result of our process to minimize credit risk. We believe this allows us to earn the yield implied at the time
of purchase, as the likelihood of a credit event for the most creditworthy issuers is lower. For example, the five largest positions in the Galliard
portfolio are typically AAA- or AA-rated, while the top five US municipal issuers in the Barclays Capital U.S. Long Credit Index are AA- or A-rated
(Figure 9).

Risk and rewards

To be a source of value, the rewards of investing in taxable municipals should be attractive relative to the risk. In this section, we broadly examine
the rewards and risks of taxable municipal investment. Then, we discuss how taxable municipals can be particularly effective as a substitute for
corporates.

Municipal risk

From a credit risk perspective, municipal issuers are very attractive relative to corporations. While there are several credit-related reasons for
this, the most compelling may be that municipal bonds in the investment grade universe are typically backed by the taxing power of the municipality
(GO bonds) or a specific revenue stream (revenue bonds).

To evaluate municipal credit risk, defaults and bankruptcies are helpful in assessing the potential downside of the investment. Despite what recent
headlines about Puerto Rico, Stockton, or Detroit might suggest, these instances are relatively uncommon.11 In fact, most municipalities
have an outstanding track record when it comes to meeting their obligations — exhibiting lower default rates, higher recoveries when defaults
occur, and fewer instances of bankruptcy — relative to corporations. Municipalities also avoid many of the event risks that are typical in
the corporate market, such as leveraged buyouts, acquisitions and other hot-button issues. Perhaps as a result of their track record and some inherent
advantages, munis typically skew higher on credit rating agency scales as well (Figure 10).

Muni defaults substantially lower than corporates
Moody’s, which has conducted an ongoing survey of municipal bond defaults since 1970, recently released a study covering 1970-201412.
The survey results show that default rates for all Moody’s-rated municipal issuers (which is only part of the investable bond universe) were substantially
lower than rated corporate issuers. In fact, average 10-year cumulative default rates — which is the percentage sum of all defaults in the
rated universe for a 10-year period — for investment-grade muni bonds totaled just 0.08% compared with 2.81% for investment-grade corporate
bonds (Figure 11). Furthermore, the average recovery rate on defaulted muni bonds was higher —nearly 64% of par, compared to 53%
of par for corporate issuers.12

In particular, the stability of investment-grade and GO municipal bonds is evident. Over the 45-year period of the study, there were only nine investment-grade
defaults from Moody’s-rated issuers. Similarly, only eight GO issuers defaulted during this time.12 This equates to a 0.02% cumulative 10-year
default rate.

Looking ahead, we expect muni bonds to continue exhibiting lower default rates than corporate bonds. Furthermore, we believe that munis will continue
to exhibit relative stability, despite the possibility that muni defaults may increase and that recovery rates may fall from their nearly impeccable
historical levels.

Bankruptcy
Bankruptcy has become an unavoidable topic in the municipal sector since both Stockton and Detroit made the largest-city-to-file-for-bankruptcy
assertion in 2013.11 Though it differs from default, investors may think of bankruptcy along similar lines. Furthermore, while there
is much uncertainty surrounding the current muni bankruptcy process, what is clear is that bankruptcy is still a developing process for municipalities.
These bankruptcy proceedings, especially for Detroit, may set precedents which could either incent or discourage other municipalities from pursuing
similar paths.

Unlike corporate entities, which use Chapter 7 and Chapter 11 of the bankruptcy code, municipalities file for bankruptcy under Chapter 9. The goal
of a Chapter 9 proceeding is to adjust debt and keep municipal bodies operating as debt disputes are settled.13 The primary difference
in corporate versus municipal bankruptcies is that municipalities cannot simply liquidate and dissolve. They need to continue to operate in order
to provide services to the local community. Despite this subtle but important difference, from a credit risk management perspective, avoiding bankruptcies,
just like avoiding defaults, is imperative.

Perhaps explaining recent bankruptcy trepidation for municipal bond investors is the relative increase in municipal bankruptcy filings. Of the entire
universe of municipal issuers (a broader subset than the Moody’s-rated issuers discussed in the previous section), 51 municipal entities have filed
for bankruptcy since January 2010.11 Of these, nine filings came from local governments. In addition, some Puerto Rican entities will
almost certainly undergo some form of restructuring in the not-too-distant future.

Importantly, however, bankruptcy does not necessarily spell impairment for bondholders. In 2012, Central Falls, Rhode Island was able to emerge from
bankruptcy without going into default, in spite of its pension cost burden. This was partially due to state legislation, which placed priority
liens on tax revenues, protecting GO bondholders, and partially due to concessions from pensioners.14

Nonetheless, new bankruptcy cases will be scrutinized for the precedents they set on certain issues such as pension and other post-retirement employment
benefit (OPEB) claims. Therefore, these bankruptcy developments underscore the importance of financial statement and security analysis in Galliard’s
research process, and in particular, Galliard’s evaluation of how pension and OPEB costs affect a municipality’s fiscal health.

A viable alternative to corporate bonds

To make a relative value comparison between investment grade taxable municipals and corporates, it is important to remember these favorable, low historical
default and low bankruptcy incident traits of municipal issuers versus those of corporate issuers. Munis also make a case for investment based
on their excess returns and attractive spreads over US Treasuries in the BABs era since 2009.

The first step in making a relative value comparison is to start with a comparable investment universe. In our view, the crux of finding relative value
in the muni sector comparable to investment grade corporates means looking at subsets of both sectors that are highly investable, attractively
yielding and creditworthy. Thus, Galliard compares the universe of AA- and better-rated taxable municipals to the universe of A- and better-rated
corporates.

Excess returns
From an excess return standpoint, Barclays U.S. Long Credit Index-eligible taxable municipals in the BABs era outperformed like-duration Treasuries
for the calendar years of 2009, 2011, 2012, 2013, and 2014 despite trailing in 2010 (Figure 12). Importantly, the excess return compares
each subsector’s return to like-duration US Treasuries, minimizing any “noise” a duration effect has on performance.

Yields and spreads
Investors like Galliard make relative value investment decisions on a forward-looking basis. Therefore, looking at spreads over US Treasuries
for taxable municipals and corporates may be more important than looking at performance history. Muni spreads have shown a paradigm shift over
the past decade. From 2004 until 2008, during the era when nearly half of the newly-issued muni bonds had a monoline insurance wrap, spreads on
thirty-year, AA- or better-rated taxable municipal bonds closely tracked those of thirty-year US Agencies. After this point, including the 2009
and 2010 BABs issuance period, muni spreads have closely tracked those of 30-year, A- or better-rated corporate spreads (Figure 13). Therefore,
the prospect of investing in comparably yielding munis with higher projected credit quality is compelling.

Summary

Galliard has come to view taxable municipals as a viable alternative to corporate bonds. Still, corporate bonds are often thought of as the de facto
credit sector investment. Perhaps this is because their $8 trillion investment universe1 commands attention. But to institutional bond
investors, we pose the question, why not use taxable municipals in addition to corporates to capitalize on the attractive risk/return tradeoff
and diversification opportunity?

The value proposition for taxable municipal bonds is generally well understood: attractive yields and low default rates. The market opportunity to
capitalize on this value has emerged thanks to the muni market having developed the size, issuance and liquidity necessary for institutional accounts.
Investors seeking to take advantage of this opportunity need to keep several key points in mind. First, ample opportunity exists outside of the
most common taxable municipal names, but building a diversified portfolio of taxable municipals requires the ability to source bonds and use robust
underwriting and monitoring practices. Additionally, taxable municipal bonds offer value as high-quality, comparably yielding substitutes for corporate
bonds. This opportunity is magnified for long credit mandates. While many investors understand this, our opinion is that the market as a whole
does not fully recognize the value proposition. This is why we continue to see taxable municipals as an attractive option for long credit investors.